Should You Trade Options Naked?

Is there a reason traders should prefer risk-defined spreads over naked options positions? That question comes up pretty consistently in strategy discussions. In more detail, as one reader put it:

"What is the advantage of an iron condor over a short strangle, or of a vertical spread over just selling the desired put or call option outright? The strangle or short option will always have a bigger credit than the condor/vertical spread. Admittedly, you need to define a stop, but this doesn't seem to change the conclusion that the naked position will give you more potential profit."

The fact that a short straddle, strangle, or naked option offers a larger up-front credit in dollar terms is meaningless unless that credit is defined in relation to the risk in the position. Absent a quantified risk level, any comparison between a risk-defined spread (like a vertical spread or an iron condor) and an unlimited-risk trade (a short strangle or naked short option) is misleading. To achieve a genuine comparison, you would want to define a stop loss point for the strangle such that a closing trade at your stop level would incur a loss equal to the maximum possible loss on a similar condor. To make a comparison between a short call or put and a vertical spread, repeat the same process. Once those risk parameters are set, you should find that, repeated over time, the return profile over time of the naked options doesn't look much different.

In fact, the short strangle should look a bit worse due to higher path dependency: a preset stop level for your strangle or short put means you'll be taken out of the position once that level is breached, while the condor or vertical spread will have extra time to potentially profit from mean reversion back across that stop level.

Part of the added risk in a naked short option or a short strangle is the fact that your stops might not work as intended. Large price jumps occur overnight or even during market hours - think, for instance, of the flash crash in May 2010. I'm not a fan of hard stop orders resting on exchanges, but even a pre-set stop order sitting at the exchange may fail you in the event of an overnight or sudden intraday gap where prices move beyond your stop. Risk-defined option spreads don't face this problem, and that gives them a relative advantage.

Another advantage of risk-defined spreads is that they allow you to "lock in" certain levels of implied volatility (IV). If the underlying declines to your predetermined stop loss point, the price of the put side of a short strangle may be higher in IV terms than the IV of the options purchased when constructing a condor, making the strangle exit consistently more expensive on a relative basis.

Finally, a risk-defined option spread like a condor or vertical spread will have more favorable margin requirements than a short strangle or naked option position. Therefore, even if you structured a strangle with stop points such that it was synthetically equivalent to a condor in profit/ loss terms, and you knew the future such that there would be no adverse jump risk, the risk-defined spread would still be preferable from the standpoint of capital efficiency.

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